Macroeconomic and financial market commentary

The day after (II).

One way or another, sooner or later, it’s going to be “Back to Mesopotamia”. More than three years ago, the Boston Consulting Group came out with a first class report that used the following words as a subtitle: “the looming threat of debt restructuring” (please translate as “the risk of massive defaulting”).

Needless to say, the BCG has been ridiculed by the Central Bank coordinated policy. Another POMO desk war casualty. That company makes a living on it’s reputation and it’s highly unlikely they are being hired by any central bank as an external consultant. I feel sorry for them because they were clear, and they were brave to say what they said. In a pre-whatever-it-takes world, it was a truism. In fact, we are long overdue for that euphemistic “restructuring”, another word that has been greatly abused.

We should try and give Cristina Kirshner a call, she’s sure to find some new extravagant term for a default. They excel at that. Defaulting is becoming a country tradition that goes deeper for nearly longer than the “asado argentino”. In point of fact, they are the front-runner for something that will spread faster than Ebola.

The “Back to Mesopotamia” report by the BCG said:

Promissory-note-tablet-Mesopotamia

“It is likely that wiping out the debt overhang will be at the heart of any solution.

Such a course of action would not be new. In ancient Mesopotamia, debt was commonplace; individual debts were recorded on clay tablets.Periodically, on the ascendancy of a new monarch, debts would be forgiven.

In other words, the slate would be wiped clean. The challenge… is how clean to wipe the slates… Western economies … have to address the significant debt load accumulated over 25 years of credit-financed economic expansion… Writing off more than six trillion euros (in Europe) would have significant implications for lenders… Total debt overhang in the US equals 11.5 trillion dollars or 77% of GDP”

Forget the 2011 debt numbers they suggested at the time of the report (and the implied suggested haircut). As a rule of thumb for the global village, the situation is much worse now (see latest BIS report), after three more years of “extend and pretend”. Public debt has increased exponentially, even if private debt has been trimmed moderately in some countries, offsetting some of the increase. No substantial deleveraging has taken place, and numbers are big enough for a nightmare scenario. The Geneva Report on the World Economy (published in September of this year by the Center for Economic Policy Research) says that the total burden of global non-financial debt, private and public, has risen from 60% of national income in 2001 to almost 200% after the crisis in 2009 and to 215% in 2013. Bloated Balance sheets of individuals, banks and NFC’s will be cut by at least 25% with the inevitable “restructuring” fad. More likely by a third or more. Creditors will be massacred.

You may consider this bizarre thinking, but it is not. There is no other way out. I wish there was.If you have the time, you can read this interesting post on debt cancellationin Mesopotamia and Egypt. Rome was no better (see picture below). I have selected the following paragraphs:

“In the present day, debt repayment has become a taboo subject. Heads of State and of governments, central banks, the IMF and the mass media, all present it as though it were inevitable, unquestionable, and obligatory. Citizens must resign themselves to paying off the debt.

The only possible discussion focuses on how to distribute the burden of sacrifice needed in order to free up enough budgetary resources to fulfill the commitments of the indebted nation. The governments who have borrowed were elected democratically, goes the reasoning, therefore their actions are legitimate. The debt must be paid off.

Debt “restructuring” in the Roman Empire

We must pierce the smoke-screen of creditors and re-establish the historical truth. Generalized debt cancellations have been enacted repeatedly throughout history. These cancellations correspond to different contexts. In the cases mentioned above, proclamations of general debt cancellation were made at the initiative of rulers concerned with upholding social peace.

In some cases, cancellations resulted from social struggles exacerbated by economic crisis and the rise of inequality. This was the case in Ancient Greece and Rome. Other scenarios can also be envisaged, such as debt cancellation decreed by indebted countries that decide to take unilateral sovereign action, and debt cancellation conceded by a victorious country to a vanquished one and/or its allies. One thing is certain: historically speaking debt has always played a major role in social and political upheaval.”

The day after will not look pretty. Economic temperature will be below freezing level for a time.Be sure to have a coat at hand.

The good thing is, there will be a day after. The financial survivors will just have to begin again.

We will surely make new mistakes, but hopefully, we shall learn from the past ones. Let’s talk about what we can do then.

Back in my post “how did we get here”, written in spanish, I outlined the three shortcuts to wealth generation that upset the Walrasian general equilibrium model in which supply always generates its own aggregate demand. Leon Walras unfortunately did not consider some aspects of economic reality, that have turned out to be significant nowadays. Public sector, money creation, and the trade flows.

If we want a sound economy, we have to accomplish a couple of major paradigmatic changes in the actual order of things. I would call it a complete system overhaul (certainly more than a “reset”).

1.- We can only spend what we produce. Credit levels should not grow substantially never again.

Data for the US. Spanish data would be obscene.

We have to allow for some leeway, but total credit as a percentage of GDP has to fluctuate around constant levels. No more credit induced demand. Demand on average must be equal to the aggregate purchasing power of the income generated by land, capital and labor in the production process.

If we want to grow aggregate demand, we have to grow the supply side. And effectively sell what is produced by it, or change the sectorial weighting. It may sound old fashioned, but that’s the way it is. No shortcuts.

2.- No more money printing.

Murray Rothbard summarizes this nicely:

“Money is not an abstract unit of account divorceable from a concrete good; it is not a useless token only good for exchanging; it is not a “claim on society”; it is not a guarantee of a fixed price level. It is simply a commodity.

It differs from other commodities in being demanded mainly as a medium of exchange. But aside from this, it is a commodity—and, like all commodities, it has an existing stock, it faces demands by people to buy and hold it, etc. Like all commodities, its “price”—in terms of other goods—is determined by the interaction of its total supply, or stock, and the total demand by people to buy and hold it. (People “buy” money by selling their goods and services for it, just as they “sell” money when they buy goods and services.)

Monetary bases should be anchored (see“un nuevo patron monetario (II)” for further details) to gross output (or any other suitable and stable macroeconomic variable). At least there should be some objective criteria to limit “politburo creativity” (like the recent 20% gold Swiss initiative). We should fire actual politburo shamans immediately, and hire new governors that will abide to objective criteria when determining the size and composition of the currency Central Bank balance sheets. Printing does not solve anything, it just delays the inevitable.

Central Banks boards should act as caretakers of the system, not as rock stars that conform it to their particular desires, or like to play with it. Flying helicopters should have been allowed only in spare leisure time (sorry Ben).

3.- Public sectors must run balanced budgets. Only long term investments can be financed with debt, and this distinction has to be enforced diligently. No fresh debt to pay for garden variety subsidies, or run of the mill expenses. Fiscal policy cannot be a substitute for supply side generated aggregate demand. We have to allow for some flexibility, but we need on average balanced budgets. Other outcomes should be treated as a criminal conduct by public servants. Keynes is dead. We should have buried him a long time ago.

Fiscal policy is gibberish if you try to use it any further than for small cyclical upturns or downturns. Public deficits mask supply side or income distribution inefficiencies, and money ends up in the pockets of the large companies (Kalecki profit equation).

We need small countries; separatist movements should be welcome. Mr. Cameron and Mr. Rajoy should read Leopold Kohr’s “the breakdown of nations”.

We need small governments, and even with small governments, we need to split their responsibilities within different autonomous public organisms.

We need a maximum of two layers of government per country (as flat a management as possible). Obviously this is easier to achieve the smaller the state is (I am aware there is also a practical limit to smallness).

We need real separate, split in sizable pieces, governmental power -in the Montesquieu tradition. But we have to go further than the three separate powers he advised at the time. States have grown more complex We need not three, but at least five separate powers to manage justice, welfare transfers (of any kind), education, public healthcare, and legislative activity. And they have to be really separate. Different management teams, elected democratically (direct vote), with board renewal in different tranches.

We need to downgrade the budget size for governments. We have to go from one massive public budget per country), ranging at this time from 25% to 50% of GDP (depending on the country) to at least five public budgets per country. Budgets for activities and payments that exceed six to eight per cent of GDP should imply separate autonomous management boards. Smaller numbers speak for better expenditure control.

Different taxes have to be targeted and linked to different specific expenditures. No big black boxes for all public money generated from taxes and the assigned to different uses depending on the subjectivity of politicians. We need to know what gets paid with every tax (there is of course a practical limit for this principle).

All Independent budgets for every one of the at least five different organisms, are to be indexed to GDP or Gross output. No automatic stabilizers (with some leeway for this). If we can spend 6% of GDP in public education, when GDP falls, the amount deployed falls. Whoever manages the educational infrastructure has to adapt to economic climates. Same thing for social transfers, justice etc …

I’ll tell you what we do not need. We don’t need a corrupt or brainless president, with more power than an French King. We need a power sharing set of presidents to manage each of the main powers of government. With towering Chinese walls, made of concrete, between them.

The will always be a bag of relevant remaining functions left to the ordinary government. But specific relevant functions have to be effectively spinned-off the central government. I love spin-offs everywhere. Small is beautiful.

5.- Free trade is a must, but trade flows have to be balanced. Beggar-thy neighbour policies have to be cracked down on. It can be done in two ways.

Taxing corporation aggregate demand use instead of corporate profits. Corporate profits should not be taxed because it is hopeless to try. Big companies do discounted tax shopping. Payroll taxes and associated costs should be negligible. The advantage of this approach is that it is simple, and can be implemented independently by the different countries. I would do it tomorrow in Spain.

With a coordinated global sales tax on all companies to be distributed according to the use of different local aggregate demand niches. If Google does 20% of its sales in France, 20% of that tax has to go to France, regardless of where they are headquartered (Luxembourg, Ireland?) or where they hire their people or manufacture their products.

It is essential to discourage Japanese, Chinese or German branded shortcuts to wealth, at the expense of other nations. And we need free trade at the same time. So we have to find a way to level out the playing field.

It’s not that difficult: an aggregate demand (sales) tax payable by the corporation (not the client) in lieu of corporate taxes and social costs linked to their labour contracts, is easy to implement. Corporate tax allows for multinationals and politicians gaming the system. Mr. Junckers latest scandal is a case in point. Some akward questions need a fast and clear reply. Maybe he will resort to lies now that things are getting tough. Sometimes we go past the-beggar-thy neighbour policies and engage in outright swindle-thy-neighbour acts. Am I right Mr. Juncker?

Of course dear Angela Merkel, Abenomics enthusiasts, and Chinese officials, will not be happy to read this. But every country has to generate enough Aggregate Demand to satisfy it’s supply side. If it does not, it has to constrict inequality and pay labour and capital adequately. Or else accept that their companies pay for the use of external aggregate demand. Free trade for all companies, on a level playing ground.

6.- Small is also beautiful in the context of the private sector and productive units.Large companies generate negative externalities. And they abuse their bargaining position with governments (see above), employees (see chart below), and clients (apple store compulsory use is a good example). We should tax them accordingly, with a clear, relevant, surcharge in order to induce downsizing to smaller levels. We need maximum corporate sizes at levels where effective free market is applicable, fighting oligopolies and employee and government abuse.

Hewlett and Packard are better off emancipating. Same thing for Ebay and Pay pal. And so on and so forth. It should be very tax-expensive to have Apple’s, Microsoft’s or Google’s size. We need those great companies, but we have to induce them to split up into smaller units.

Like the Marlon Brando when playing “the Godfather”, we have to invite them in a way that makes a “no reply” unfeasible. It is not only about “too big to fail”. It is also about too big to allow for effective bargaining, and “perfect competition”. It is also about minimizing corruption. Also about board effective accountability to shareholders. And about outsized salaries and stock option payments to the company executives. We cannot allow large companies to rule the world “de facto”.

7.- Tax regimes have to be simple, and taxable concepts are to be quantitatively broad based. We need low tax rates on high tax bases, with no exemptions or loopholes. Fiscal paradises have to be outlawed. No free trade with countries that do not provide full disclosure of their bank accounts. No more corrupt politicians and establishment.

We need only three to four basic taxes, with an specific governmental function destination for the income each one generates. We have to identify payments with uses for public money.

8.- Capital gains taxes are one of the ways to ensure inequality does not grow. Capital gains on paper must also be taxed. As a consequence, the tax rate on capital gains can be brought down significantly. Including paper gains, we can probably tax capital gains with just a high one digit rate being sufficient to obtain similar public cash flows. As Warren Buffet explicitly admits, he does not get taxed enough. It’s not about lifting already high marginal tax rates that discourage work, it is about taxing wealth generation in all its forms. It is the only way to efficiently tax the rich. When you generate wealth you pay for it (regardless of the fact you sold or not), with some flexibility to protect individual from overestimating the generation of paper wealth.

I am not suggesting we have to tax more.As a rule, I think tax levels are too high. Tax rates are too high, and total tax incomes are too high. In France they are obscene.

All I say is that the same income should be generated with a lower tax rate, both on material and paper gains, instead of only taxing the former.

9.- Payroll taxes and social security or retirement associated costs have to be suppressed. We need a global income tax that bears no distinction between payroll income, and independant professional income.

We cannot tax the act of hiring somebody. We need to fully employ the highest percentage of the population that we can. I don’t care for unemployment figures, be it U3 or U6. Labor participation rates is the relevant statistic. How many people are busy ( and remain mentally healthy), and contribute to wealth generation, vs the rest, is the key issue.

We have a lot of work to do the day after. Mostly, painful walking back the road we’ve been speeding down for the last 25 years. It will take time. Albeit grudgingly, we should start today. The economic system has to be sound. No “extend and pretend” “make up” policies should be allowed. Beginning today.

Poverty should be assumed only for the shortest possible period following the day after. ZEPP (zero poverty policy) should be the new macro target. Just look at the girl in the featured image; her charming eyes … and the garbage around her. I am ashamed. You ought to be ashamed as well. What comes first: paying (or pretending to pay) ludicrous accumulated debt, or trying to save the girl? I have no doubts, creditors were as careless as debtors. The day after should come asap. It will be a brave new world, but only after we get rid of the past.